Behavioral Finance and Your Portfolio

16Emotional Bias #1: Loss Aversion Bias

Win as if you were used to it, lose as if you enjoyed it for a change.

—Ralph Waldo Emerson

Bias Description

Bias Name: Loss aversion bias

Bias type: Emotional

General Description

Loss aversion bias was developed by Daniel Kahneman and Amos Tversky in 1979, as part of the original prospect theory,¹ specifically in response to prospect theory's observation that people generally feel a stronger impulse to avoid losses than to acquire gains. A number of studies on loss aversion have given birth to a common rule of thumb: psychologically, the possibility of a loss is on average twice as powerful a motivator as the possibility of making a gain of equal magnitude; that is, a loss-averse person might demand, at minimum, a $2 gain for every $1 placed at risk. In this scenario, risks that don't “pay double” are unacceptable.

Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. Some industry veterans have coined a diagnosis of “get-even-itis” to describe this widespread affliction, whereby a person waits too long for an investment to rebound following a loss. Get-even-itis can be dangerous because, often, the best response to a loss is to sell the offending security and to redeploy those assets. Similarly, loss aversion bias can make investors dwell excessively on risk avoidance when evaluating possible gains, since dodging a loss is a more urgent concern than ...